In an important research paper written by Yale Business School economists Even G. Gatev, William Goetzmann, and K. Geert Rouwenhorst, the authors attempted to prove that pairs trading is profitable. Using a large set of data from 1967 to 1997, the trio found that over any six-month trading period, the pairs trade averaged a +12% return.

You have now overlaid the chart of Z (blue) on the chart of EWU (red). We scan the charts of 2 assets to see if they https://www.forex-world.net/ diverge and converge. Stay on top of upcoming market-moving events with our customisable economic calendar.

1. An individual trader's resources and expected trade duration will affect each of these factors, but the structure is functionally the same in all cases.
2. You have now overlaid the chart of Z (blue) on the chart of EWU (red).
3. If you are running a pair trading strategy on stocks, you probably need to run the strategy on more than a single pair of stocks.
4. We recommend that you seek independent advice and ensure you fully understand the risks involved before trading.
5. Maybe you can use the US 2-10 bond spread to lead the US stock ETF and a German 2-10 bond spread to lead the European stock ETF.

We look at pairs trading – what it is, how investors can implement it as a strategy, and both the positives and negatives of using it. You don’t need your pairs trade to return huge profits per trade. You will know when to enter the trade and when not to, even as the 2 assets diverge and everyone else is entering the pairs trade.

What Is Pairs Trading?

They are both wandering around, but they are both independent so there is no meaningful connection to their movements. However, a man walking his dog is an example of correlated movement. The dog may wander away from the man, but it will eventually come back. The man and his dog are correlated, and the times when the dog moves away from the man are examples of the ratio between two markets becoming stretched. To identify this, the trader can use Bollinger Bands, which are indicators that contain upper and lower bands that are two standard deviations from the ratio’s price. When the ratio hits the top or bottom Bollinger band, then a trading opportunity is created.

It seeks to maintain neutrality by keeping the exposure on each trade identical. Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level https://www.forexbox.info/ of experience, and risk appetite. You could sustain a loss of some or all of your initial investment and should not invest money that you cannot afford to lose. Below is a weekly chart of the price ratio between Ford and GM (calculated by dividing Ford's stock price by GM's stock price).

How much does trading cost?

To distinguish profitable results from plain luck, their test included conservative estimates of transaction costs and randomly selected pairs. Technical analysis focuses on market action — specifically, volume and price. When considering which stocks to buy or sell, you should use the approach that you're most comfortable with. In a nutshell, pairs trading works by betting that 2 or more securities will diverge or converge in price. The trader bets that a $50 stock and a $55 stock, for instance, will either have a larger or smaller spread ($5 in this case) when the trade is closed. Divergence traders will like to see the spread increase while convergence traders will prefer to see the spread decrease.

However, companies in the same sector, such as supermarkets, or mining, usually see their correlations remain constant. Another way to do this is to run a “pairs” trading strategy that consists of more than 2 assets per strategy. Another example is that your https://www.currency-trading.org/ pairs trade might only work during volatile periods. In this case, you might only want to execute it during the periods that work. Moreover, profits and losses from these idiosyncratic stock effects might cancel out because you have exposure to many stocks.

Pairs trading has the potential to achieve profits through simple and relatively low-risk positions. The pairs trade is market-neutral, meaning the direction of the overall market does not affect its win or loss. To illustrate the potential profit of the pairs trade strategy, consider Stock A and Stock B, which have a high correlation of 0.95. The two stocks deviate from their historical trending correlation in the short-term, with a correlation of 0.50. The strategy has reduced directional risk, since a trader that goes long or short faces the possibility that the market will move in an opposite direction to that of the trade.

While it sounds like an ideal strategy to avoid the risks of uni-directional trading, pairs trading is not a magic formula. Correlations can change over time, so as ever it is important to manage risk correctly, risking only 2% of your capital on each trade. Indeed, given that a pairs trader is using two rather than one position, perhaps this should be dialed down to 1% of capital for each trade.

One is that the pairs trade relies on a high statistical correlation between two securities. Most pairs trades will require a correlation of 0.80, which can be challenging to identify. Second, while historical trends can be accurate, past prices are not always indicative of future trends. Requiring only a correlation of 0.80 can also decrease the likelihood of the expected outcome. A pairs trade strategy is based on the historical correlation of two securities. The securities in a pairs trade must have a high positive correlation, which is the primary driver behind the strategy’s profits.

Or, the end-of-day timings might be different for the 2 assets. This information has been prepared by IG, a trading name of IG US LLC. This material does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. You should not treat any opinion expressed in this material as a specific inducement to make any investment or follow any strategy, but only as an expression of opinion. This material does not consider your investment objectives, financial situation or needs and is not intended as recommendations appropriate for you.

It can also be referred to as market neutral or statistical arbitrage. Pairs trading was first introduced in the mid-1980s by a group of technical analyst researchers that were employed by Morgan Stanley, the multinational investment bank and financial services company. The pairs trade strategy uses statistical and technical analysis to seek out potential market-neutral profits. To devise a pairs trading strategy, a trader will need the price data for the two markets, and then create a ratio (one market’s price divided by the other). When the ratio between the two moves outside its normal range then a trading opportunity is created. Pepsi (PEP) and Coca-Cola (KO) are different companies that create a similar product, soda pop.

How does pairs trading work?

It includes selecting a trading universe, constructing and testing a model, if one is to be used, and creating general buy and sell guidelines. An individual trader's resources and expected trade duration will affect each of these factors, but the structure is functionally the same in all cases. The aim of pairs trading is to bet that, if the prices of 2 assets diverge, they will converge eventually. Pairs trading is a strategy that involves using two positions, one short and one long, on two markets with high correlation. It can be used across equities, indices, FX or commodities, or any combination of markets.

How to Design a Pairs Trading Strategy for the Real-World?

I do believe that in general, it is easier to find non-stock assets that move similarly. If you are a $10 billion quant hedge fund, then yes, you have the resources to collect plenty of data. We then retrospectively look for plausible reasons for the similar movement, or we might dismiss it as coincidence. The bottom-up method entails collecting all the data under the sun and checking which 2 (or more) assets behave similarly. E.g. Futures and ETFs of the same products should behave similarly.

After a selection process has been defined, a trader must use that process to generate a list of candidate trades. If relying on manual research, the results of this inquiry constitute the list; if relying on a model, the model’s output serves as the list of candidates. The frequency of the procedure will also need to be considered. For instance, a stock might move 1% a day on average, while a cryptocurrency coin moves 5% a day on average.